Erstwhile mechanical engineer and Forbes Executive Editor, with MBA from NYU. In 15 years at Forbes I covered large corporations, money managers and self-made wealth builders---and the myriad trials they all face. Joined the tech-startup ranks in 2014 as co-founder and CFO of Eyes/Only, a luxury-experience portal for high-net-worth individuals. If the mood strikes (and especially if you have a tasty-tequila rec), please send your thoughts to brett@eyeson.ly.

The Truth About What Facebook Is Really Worth

When the fiasco over FacebookFacebook’s bungled public offering finally subsides, one very hard question will remain: What are the shares of this company actually worth?

Given how experienced stock pickers go about their art, the gyrations over the last few days are virtually beside the point. Here’s why:

The last time you bought stock in a company, you probably had a reasonable argument for why you thought its price would rise: the company makes dependable products that people need, it has competent leaders at its helm, the shares look cheap relative to those of inferior rivals, etc. You also might even know (in theory) how sophisticated participants in the market attempt to arrive at a fair value for those shares.

A quick refresher on that last part, just in case: The price of a share of stock is based on how much money a company can potentially earn in the future. Makes sense: Ultimately, companies are only worth something if they can generate positive cash flows; otherwise, the owners should just fire the staff, sell the buildings, furniture and equipment, and move on.

Once you’ve estimated those cash flows, you must convert them to present dollars by dividing them at some appropriate rate equal to the return you might have earned investing your money in a similarly risky venture. That’s it: Estimate the cash streams and discount them to present dollars.

Doing a traditional “discounted cash flow” (DCF) valuation calculation isn’t rocket science, but doing it right requires a fair bit of work and a ton of educated guessing. (There are less rigorous valuation techniques, like price-to-earnings ratios and the like, but DCF is the king.)

Let’s focus on the guessing part of this game, and what it means—or doesn’t—for a company like Facebook.

A valuation model basically comes in two pieces: the earnings to come in the next five years (which you can approximate with some confidence) and the earnings to come all the years after that (which you estimate by waving what amounts to a wet finger in the air). That second piece is called the “terminal value.” Sum up those two pieces, divide by the number of shares, and Voila: you have the total present value of the stock today.

The first piece is hard enough to get a handle on, depending on what industry a company is in. If the company manufactures sheet steel, estimating earnings for each of the next five years is relatively easy—assuming the global economy doesn’t implode or the world doesn’t discover a stronger, cheaper substitute for steel between now and 2017.

If, however, the company makes, say, designer jeans or smart phones, the estimates get a little fuzzier, given how finicky consumers can be. If the company sells online advertising on a social networking platform, well, who knows what that market will look like in the next five months, let alone in the next five years?

Here’s the really unsettling part: The first piece of the valuation model (comprised of the cash flows over the next five years) might only account for a quarter of the overall valuation. The second piece (the terminal value) accounts for the rest, along with the value of any real estate, marketable securities and cash. In other words: Most of the stock price is tied up in the terminal value.

How hard is it to calculate the correct terminal value? Really hard. I won’t derive the formula, but here it is:

TV = cash flow in Year 6 / (r – g)

In the formula, “r” equals the long-term discount rate, and “g” equals the company’s long-term growth rate (assumed to smooth and flatten over time).

While the arithmetic is easy, you can see how even small changes in that denominator would wildly swing the terminal value.

Facebook logo (Photo credit: Wikipedia)

Consider: In a May 7 research report, Brian Wieser, an equity analyst with Pivotal Research Group, kindly provided a matrix of potential valuations for Facebook based on different assumptions for both the long-term discount rate and the long-term growth rate. Just based on changes in the resulting terminal value, Facebook’s valuation would swing between $23 and $81, and the company’s total market value between $59 billion and $207 billion. That’s a big swing. In Wieser’s model, Facebook’s terminal value accounts for fully two-thirds of its overall worth. He thinks Facebook’s shares are fairly priced at $30.

“The change [in price] can be pretty substantial with a change in discount rate or growth rate,” says Wieser. “My philosophy on this: Establish a benchmark you’re comfortable with—in this case, GoogleGoogle—and assess the metrics on discount rate or growth rate by comparison.” He’s right: That’s about all you can do.

So what does all of this glorified guesswork mean for Facebook shareholders and those watching anxiously from the sidelines?

If you’re placing daily bets on Facebook shares (and I sincerely hope most of you aren’t), then obviously you care a lot if they lurch 15% in either direction. But as to whether the company is intrinsically worth $30 or $40 or anything in between, much of what’s in that number, by definition, is noise at the moment.

Social networking is no fad, and Facebook is a giant. It’s worth…something. As to how much, even talented analysts can’t know with precision. Eventually (though probably not for awhile), the company’s cash flows will coalesce around some better-defined trajectory, the valuation models will firm up and comfort levels will rise.

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As with all things, my friend. Just trying to make sure that our readers are able to gauge for themselves, with some accuracy, how willing they are. (Our job, as ink-stained wretches, in a nutshell.) Would love for readers to offer their suggestions for making intelligent assumptions on this one. Professor Aswath Damodaran (my financial-modeling prof at NYU bschool) took a stab in a guest post on Eric Savitz’s blog on May 22. Very smart guy (to say the least). Worth a read.

Great article Brett. You hit the nail on the head- Facebook’s value is yet to be determined and the stock market shows the aggregate of what people believe. Whether or not it lives up to the hype remains to be seen, but I think most wise investors are staying clear because of the risks in mobile, competition, user sentiment and the trouble of monetizing a social network without alienating the users. I wouldn’t say Facebook is a fad, but it’s also not invincible and will have to breed creativity from within if they are going to be on Google or Apple’s level. I just have sympathy for the non-institutional investors who were either duped or naive about any IPO pop. A lot of money changed hands recently and it came at the expense of post-IPO buyers.

Many thanks, Ryan. Why IPOs “pop” or don’t is a study in itself. If they pop, the company (and its investment bankers) left precious capital on the table; if they crater, the hungry hordes get creamed. Institutional investors have to play this game (and many have drinking habits to show for it). Folks at home don’t have to play, unless they want to take that sort of risk and have a few bucks to burn. My opinion: There’s no excuse for being “duped” anymore. Those who still think they can make a quick killing on very speculative stocks deserve their fate.

Great article. Why do I get the feeling that the buying stock is pretty much like buying lottery tickets. Has anything changed over the years?

Yes,

Less Integrity (that is debatable) More Greed and people looking for easy money without working for it. Lightening speed reaction that never used to occur because of online instant access. Herd Mentality and not wanting to “miss out on an opportunity” Big institutional investors moving stock values on sheer volume. Unfair and unethical things being done right under our noses.

Enough already! I would not buy this stock because it is too popular and overvalued due to its popularity. Frankly, I am not 100% sure how they make their money and what they really have in assets besides cash. Let it sit for a few months and buy it when it is at a realistic price.

From the standpoint of someone who played the Internet marketing game – people into social networking are essentially only interested in posting drivel about themselves or sharing videos and cute cat pictures. The big thing now is nauseating inspirational sayings.

As as far as using FB or any other social netwroking site to market something, it’s pretty much a lost cause.

Presently, on my FB page about the “scientifically targeted”ads I get are for Ukrainian Brides and somewhat dubious investment advisers from Nigeria.

I always knew that about the only thing FB was really worth was a few billion Zynga dollars and a herd of Farmville goats.

By the way, my Farmville estate is up for sale – $22B Zyngas or $16B US: contact me on my FB page if you’re interested.

Social networking is not a fad, it is really a replacement for the postal service. We used to send picture postcards to share our lives with friends and family. Now we post photos on Facebook instantly. The postal services covers its costs by sending us junk mail ads. Facebook covers its costs with junk ads from the same advertisers.

IPOs stocks are one of the most risky in that they not market tested with almost no disclosure history. The stocks with the most disclosure are ones that survive a bankruptcy: everything was out on the table in the bankruptcy courts.

ALL OF YOU ARE WRONG. FB is not more than 12 $$ a share. Do you know why?? Is so easy, so easy… look at this FB has more than a 900 million user. so!!! that means nothing cause 900 million users do not mean profit. Or. hello, a lot of this user are kids,no active users; but the best part of that is… that from those 900 millions user only 10 to 12 % use advertise. and if there is not advertising there is not profit at all. DA. i know that fb has games, ok how many millions does fb makes on latin America with that…?? 0 cero. that is a very negative number knowing that more than 100 million use fb in south America. I’m sorry but this makes me realize that wall street has no brains at all. To have this FB thing worth that much money they need to do three things. 1-value the company on people that spend money on it. amazon is worth a lot of money because they sell you information to all the retail companies they know, they have and know every person that sells some product. fb does not sell much. but they have you info. 2- Media, tv,sports,technology, invest in countries that have no power to buy anything change the world from scratch. DO not do it. FB will fail. 3- there is A million ways to make FB the best thing ever created. If i’m right call me when the stock hits 10$ a share. THANKS.